Absorption Costing
and GAAP
Two Ways To Treat Fixed
Manufacturing Overhead
• Variable Costing
• Absorption Costing
• a.k.a. direct costing • a.k.a. full costing
• Fixed Mfg O/H is a
Period Cost
• Fixed Mfg O/H is an
Inventoriable Cost
• Focus is on Contribution Margin
• Focus is on Gross
Margin
• This isn’t G.A.A.P.
• This is G.A.A.P.
Variable Costing
Absorption Costing
What Costs Are
Included In Inventory?
Non-manufacturing
costs (e.g. selling,
general & admin.)
Variable manufacturing costs (& any
direct, fixed costs)
Fixed
Manufacturing
Overhead
Accounting Research
Bulletins
• Issued by the Committee on Accounting
Procedure
• In 1953, ARB 43 revised and/or restated all
previous bulletins.
• Bulletins 44 through 51 were issued
subsequently.
• In 1959, the newly-formed Accounting
Principles Board passed a resolution
establishing the continuing authority of the
ARBs, until such time as the APB issued new
rules replacing specific provisions.
ARB Chapter 4, Inventory Pricing
Statement 2
“A major objective of accounting for inventories is
the proper determination of income through the
process of matching appropriate costs against
revenues.”
ARB Chapter 4, Inventory Pricing
Discussion of Statement 2
“In accounting for the goods in the inventory at
any point of time, the major objective is the
matching of appropriate costs against revenues
in order that there may be a proper
determination of the realized income. Thus, the
inventory at any given date is the balance of
costs applicable to goods on hand remaining
after the matching of absorbed costs with
concurrent revenues.”
ARB Chapter 4, Inventory Pricing
Statement 3
“The primary basis of accounting for inventories
is cost, which has been defined generally as the
price paid or consideration given to acquire an
asset. As applied to inventories, cost means in
principle the sum of the applicable expenditures
and charges directly or indirectly incurred in
bringing an article to its existing condition and
location.”
ARB Chapter 4, inventory pricing
Discussion of Statement 3
“The definition of cost as applied to inventories is
understood to mean acquisition and production
cost, and its determination involves many
problems. … Under some circumstances, items
such as idle facility expense, excessive spoilage,
double freight, and rehandling costs may be so
abnormal as to require treatment as current
period charges rather than as a portion of the
inventory cost. Also, general and administrative
expenses should be included as period charges,
except for the portion of such expenses that may
be clearly related to production and thus
constitute a part of inventory costs ….”
ARB Chapter 4, inventory pricing
Discussion of Statement 3
“It should also be recognized that the
exclusion of all overhead from inventory
costs does not constitute an accepted
accounting procedure.”
Cost Allocations to Inventory
Steve Landekich
-
An article reporting the results of a
survey.
-
The article appeared in the magazine
Management Accounting.
-
March 1973.
Cost Allocations to Inventory
Steve Landekich
-
The principal survey question was:
“do you allocate (at least on a broadbrush basis) all expenditures that are
indirectly related to production?”
-
The question was asked separately for
annual financial reporting and for
management (internal) reporting.
-
1,200 usable responses were received.
Cost Allocations to Inventory
Steve Landekich
Financial
Reporting
Yes, we
allocate all
expenses.
No, we do
not allocate
all expenses.
Internal
Reporting
44%
42%
56%
58%
Cost Allocations to Inventory
Steve Landekich
For the firms that do not allocate all expenses,
here is the percentage of those firms that do not
allocate each type of expense:
Service department costs:
23 – 69%
General and administrative:
75 – 87%
Depreciation:
24%
Property taxes:
28%
Repairs and maintenance:
17%
Fire and casualty insurance:
26%
Cost Allocations to Inventory
Steve Landekich
For the firms that do not allocate all expenses,
here are the reasons given, in decreasing order
of frequency:
1. Method of allocation would be too arbitrary
2. The result would be misleading
3. Amount is not significant
4. Not considered inventory costs
5. Considered period costs
SFAS 151, Inventory Costs
An amendment to ARB No. 43
“Under some circumstances, items such as idle
facility expense, excessive spoilage, double
freight, and rehandling costs may be so abnormal
as to require treatment as current period charges
rather than as a portion of the inventory cost.”
This statement requires that those items be
recognized as current-period charges regardless
of whether they meet the criterion of “so
abnormal.” In addition, this Statement requires
that allocation of fixed production overhead to
the costs of conversion be based on the normal
capacity of the production facilities.
SFAS 151
• Purpose: to improve comparability of
cross-border financial reporting; to align
with the International Accounting
Standards Board (IAS #2).
• ARB 43 did not define “so abnormal.”
• SFAS 151 was approved unanimously by
the FASB in 2004, and applies to
inventory costs incurred during fiscal
years beginning after June 15, 2005.
SFAS 151
Variable production overheads are allocated to
each unit of production on the basis of the actual
use of the production facilities.
However, the allocation of fixed production
overheads to the costs of conversion is based on
the normal capacity of the production facilities.
SFAS 151
Normal capacity refers to a range of production
levels.
Normal capacity is the production expected to be
achieved over a number of periods or seasons
under normal circumstances, taking into account
the loss of capacity resulting from planned
maintenance.
Some variation in production levels from period
to period is expected and establishes the range of
normal capacity.
SFAS 151
The range of normal capacity will vary based on
business- and industry-specific factors.
Judgment is required to determine when a
production level is abnormally low (that is,
outside the range of expected variation in
production).
Examples of factors that might be anticipated to
cause an abnormally low production level include
significantly reduced demand, labor and
materials shortages, and unplanned facility or
equipment downtime.
SFAS 151
The actual level of production may be used if it
approximates normal capacity.
In periods of abnormally high production, the
amount of fixed overhead allocated to each unit
of production is decreased to that inventories are
not measured above cost.
The amount of fixed overhead allocated to each
unit of production is not increased as a
consequence of abnormally low production or idle
plant.
SFAS 151
Unallocated overheads are recognized as an
expense in the period in which they are incurred.
Other items such as abnormal freight, handling
costs, and amounts of wasted materials
(spoilage) require treatment as current period
charges rather than as a portion of the inventory
cost.
SFAS 151
Also, under most circumstances, general and
administrative expenses should be included as
period charges, except for the portion of such
expenses that may be clearly related to
production and thus constitute a part of inventory
costs (product charges).
Selling expenses constitute no part of inventory
costs.
SFAS 151
Many respondents to the Exposure Draft … noted
that incorporating the guidance from IAS 2 that
states that fixed production overhead costs
should be allocated to inventory based on the
“normal capacity” of the production facility would
result in recognition of all unfavorable volume
variances as a period expense, while favorable
variances that are normal would be recognized in
inventory.
Those respondents noted that under ARB 43,
Chapter 4, volume variances are recognized as a
period cost only when the “so abnormal” criterion
is met.
SFAS 151
… to address respondents’ concerns, the Board
decided that the amendment should include
guidance slightly more detailed than that in IAS 2
regarding normal capacity.
In particular, the Board decided to add guidance
clarifying that normal capacity refers to a range
of production levels within which ordinary
variations in production levels are expected.
The Board believes the amendment to ARB 43,
Chapter 4, as modified, will not lead to significant
changes in inventory accounting practice.